Southern California office market continues to weaken

Roger Vincent

Southern California's long-suffering office market continued to weaken in the first quarter as demand slid and rents fell, a pattern expected to carry on through the months ahead.

The trend is dreary for landlords, who have seen their incomes fall for more than a year, but a boost for office renters who are looking for new space or negotiating to renew their existing leases as they expire.

"Rents are as low as they have been in a number of years," said Joe Vargas, executive vice president of real estate brokerage Cushman & Wakefield.

With its long lease agreements -- five years is typical -- commercial real estate is a lagging indicator of the economy. So even though the nation's economic outlook is showing some signs of improvement, the office market has yet to digest the downturn.

Overall office vacancy in Los Angeles County reached 17.6% in the first quarter, up from 14.3% a year earlier, according to Cushman & Wakefield. The average rent landlords asked for dropped to $2.60 a square foot per month from $2.82 in last year's first quarter.

"I think we are still searching for some sort of bottom" in office rents and vacancies, said J.C. Casillas, who oversees Southern California research at brokerage Grubb & Ellis. "Employment is not improving any time soon."

With California unemployment hovering at post-World War II highs of more than 12%, companies have yet to start hiring on a scale that would require them to rent larger quarters. In fact, many businesses still have more space than they need after conducting layoffs. As a result, they often try to sublet their extra space to other businesses or downsize their offices as their leases expire. Other businesses have simply closed during the recession.

Landlords experienced a net loss of 9.6 million square feet of rented space last year in Los Angeles, Orange, Riverside and San Bernardino counties. In the first quarter, an additional 967,000 square feet fell off landlords' rolls.

When occupancy and rents fall, so do property values, because potential buyers judge an office building's worth by its income stream. With income from rents -- and hence values -- uncertain and financing hard to come by, sales of office buildings have been rare for the last year.

Southern California vacancy rates aren't quite as bad as they were during the last real estate downturn in late 2002 and early 2003, Casillas said, but they are still trending the wrong way.

With so much space vacant, office development is nearly at a standstill. That means the loss of construction and other development expenditures that contribute billions of dollars to the Southern California economy during boom years.

The long bleat of bad economic news has forced landlords to lower rents and boost incentives -- such as free parking and periods of free rent -- for new tenants to sign leases.

Last year in the first quarter, many landlords were holding out hope of getting higher prices. On the Westside, the region's most expensive market, the average asking rent was $4 a square foot and some owners sought more than $6. This year the average asking rent was $3.38 a square foot in the first quarter.

"Landlords understand where the market is," Cushman's Vargas said. "More deals are being done than at the same time last year."

That may be only out of necessity, broker Jerry Porter said. "Tenants whose leases are expiring are taking negotiations down to the bitter end."

In some cases, lease discussions have been going on for as long as two years, said Porter, chairman of Cresa Partners. "We're really seeing much more brinkmanship on both sides."

With plenty of space on the market, tenants are under less pressure to make commitments, he said, and often hope to postpone real estate decisions as they work on strategies to cope with the recession. Sony Pictures Entertainment, for example, announced plans in February to lay off 450 employees at the same time that Porter was negotiating an office lease for the company, he said.

Many leases now being signed are short term, he said, such as renewals that last a year. Tenants are reluctant to commit to longer deals when they are unclear about their business plans.

"We are in for an extended period of reduced demand and oversupply," Porter said. "I just don't see what changes the equation for the next five years."